On the Near-Impossibility of Financial Reform

October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February. –Mark Twain, Pudd’nhead Wilson

Section 1

JPMorgan Chase chief Jamie Dimon appeared before Congress this week to defend his bank from public criticism after one of the bank’s traders, Bruno Michel Iksil, nicknamed “the London Whale,” accrued $2 billion in trading losses earlier this year. The question before Congress was not how JPMorgan Chase could possibly have lost such a vast sum of money, but rather whether the bank had violated the Volcker Rule, a post-2008 financial regulation which bans major banks from engaging in proprietary trading—betting their own money, as opposed to their clients’, in the open market in order to make money.

Dimon’s defense of his bank rested on a distinction between proprietary trading—outright speculation with which, according to Dimon, the Whale was most certainly not involved—and hedging, or putting on an offsetting trade to counteract a portfolio’s existing risk. The Volcker Rule permits hedging—after all, the purpose of the regulation is to reduce banks’ risk exposure, so it would hardly make sense to ban trades whose goal is to offset risk. But it is very hard to tell the difference between hedging and speculative trading. Dimon made the case that the vast complexity of a bank like JPMorgan is too vast for regulators to fully comprehend, and criticized the Volcker Rule and its attempt to arbitrate the blurry line between risk-taking and risk-reducing behavior. What appeared as outright speculation, he claimed, was a form of protection intended to neutralize the bank’s exposure to the market.

We should certainly hope that the House of Dimon is doing something to mitigate investment risk. With a hefty stack of outstanding loans somewhere near $700 billion and an investment portfolio a few nickels shy of $1 trillion, there should be myriad opportunities to put on enormous hedges. Looking at the bank’s full set of knick-knacks and what’s-its, we come to a balance sheet number of $2.3 trillion as of March 2012, which really is a lot of sushi. In comparison, the London Whale’s $2 billion barely moves the needle, though we can agree that the amount of forgone eel avocado rolls is tragically in the millions. And yet the JPMorgan chief investment office is surely not flagellating itself much over this.

Dimon’s argument has some merit. It may be surprising that a trade intended to offset risk turned out to be so massively risky, but hedges do go wrong, and it is indeed difficult to distinguish between hedging and proprietary trading. But the controversy surrounding JPMorgan’s loss raises larger issues about financial regulation and risk exposure. Despite the fact that JPMorgan officially shut down its proprietary trading unit in 2010, we can still be sure that a great sum of their shiny money does represent risky trades on behalf of the bank’s cherished shareholders. After all, the details of the Dodd-Frank Wall Street Reform Act are still being hashed out, and proprietary trading is far from gone. In a moment of perplexity, one congressman fittingly evoked Shakespeare: “a hedge or not a hedge, that is the question.” We will be at pains to show that this is the wrong question entirely.

Section 2

It is imperative to understand banks’ relationship to risk before we can even discussing hedging it. Banks, by definition, lend money—it is their basic business model. Risk comes into play every single time a bank makes a loan. Loans are risky assets because the borrower might just decide to stop paying, in which case the bank loses its principal. On top of that, the interest rate on the loans is subject to market fluctuations, which makes the payment stream even more unpredictable. But banks are not just exposed to credit risk as lenders—they face liabilities as well. As Bob Dylan sang it, they “gotta serve somebody,” as they are often borrowing money to lend it out. Borrowing on the cheap from unwitting savers and lending it at higher rates is the quick and dirty business model of every bank. So a typical commercial bank is by definition overflowing with risk, even when avoiding all of the sketchy junk loans, derivatives, and structured products about which the public is constantly up in arms. The problem is that when one is funding the underfunded, the return stream is highly unpredictable. Dwelling on this is very unpleasant during afternoon golf, and unthinkable while sailing.

There has been a new development to this age-old business over the past ten years, and it’s the type of activity that the Volcker Rule in its original form—the simple three-page proposal which later became hundreds of pages of financial legalese—sought to prohibit. In building up large in-house proprietary trading desks, large investment banks have dramatically shifted away from their function as middlemen between borrowers and lenders: they have begun to trade on their own account. In the decades preceding the 2008 financial crisis, banks were making huge amounts of money from proprietary trading.

Proprietary trading was born from market making, the process through which an investment bank makes a two-way market in various securities. In other words, the bank stands ready at all times to buy securities at an advertised purchase price and to sell those securities at a higher advertised selling price, typically at a very quick rate of turnover. The bank pockets the spread between the two price points as their profit; it’s a commission for the privilege of a fast and efficient transaction. Eventually, banks were able to carve out market making style groups that functioned as internal speculators.

Banks’ success in this field is no mystery: they have always been repositories of privileged information simply by virtue of being central hubs in financial markets. Once the markets got complex and customized enough, there were massive opportunities for well-positioned insiders to profit from their understanding of the market’s ebbs and flows. Eventually, some of these carved-out prop trading groups were instructed to focus purely on speculation rather than indifferently making markets. It’s a far riskier business model than traditional banking. And yet within this model itself, the line between speculating, hedging, and market making is virtually indistinguishable apart from their intent. And intent is notoriously hard to regulate.

It seems as though it should be easy to figure out whether or not a given trade was a hedge: we could simply inquire as to which other position it was a hedge for, and try to figure out whether it would have made sense to offset that particular risk in this particular way. Unfortunately, matters are more complicated. Understanding the risks in a gargantuan investment portfolio is not as simple as adding up each individual position and netting it against a particular hedge. Banks manage risk across multiple dimensions and timeframes, and their trades are structured to pay off in wide-ranging scenarios. A hedge might be put on for the entire portfolio, or for individual unrelated positions. You can find financial instruments to hedge out currency risk, or even a given level of volatility in the market. While this concept seems confusing, somehow Congress seems to have grasped it, and so they have carved out aggregated position hedging from activities banned by the Volcker Rule. Unfortunately for us, this has only made the Rule more confusing, and more complex in its application.

Section 3

The Volcker Rule has become one of the most contentious pieces of financial legislation ever devised. This is fitting, as Paul Volcker's tenure at the Federal Reserve from 1979 to 1987 provoked some of strongest political attacks in the Fed’s history. Faced with rampant inflation in the early 1980s, the Fed severely tightened the supply of money to counteract the rapid decrease in the value of the dollar. The Fed effectively raised interest rates to 20% levels for several years, which made borrowing insanely expensive, slowed down the economy, and thereby lowered prices and wages. Volcker’s strategy successfully put an end to the inflation, but not without some painful austerity that led farmers to blockade the Fed’s DC office with their tractors. It’s a sensible approach from a structural, economic perspective, but oh does it hurt in its application.

Volcker took his sensibility to a new level when appointed by Barack Obama to be the chair of the Economic Recovery Advisory Board in 2009. High on Volcker’s list of concerns was preventing risky proprietary trading by FDIC-insured depositary institutions. This idea was dubbed the “Volcker Rule”¹ and included in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

Though it is still being finalized in the congressional sausage factory, the proposed Volcker Rule is primarily meant to prohibit U.S. banks from engaging in risky trading for profit. In the spirit of this idea, the Rule will also limit hedge fund and private-equity fund investments to 3% of the bank’s “core capital”—its equity and reserves. Under this rule, U.S. banks would no longer be able to focus on proprietary trading; they would be forced to return to their roots and focus on providing financial services to customers. Small banks which lack the capital and expertise to engage in serious prop trading won’t be much affected by the rule; only the largest banks, Goldman Sachs Group Inc., Bank of America Corp., and JPMorgan Chase & Co., will be seriously impacted.

Alas, by 2012 legislators have transformed Volcker’s three-page proposal into an oppressive behemoth of over 500 pages. Undoubtedly things have gotten complex. Expensive lobbyists have worked diligently to create all of the crucial exemptions. The premise of the Volcker Rule is far too clear and simple to impose on a complex, interconnected financial industry without causing grossly expensive problems for financial professionals. The Epicurean Dealmaker, an anonymous blogger, writes: “I’m sure they offered all sorts of eminently reasonable objections to straightforward implementation of a separation between proprietary trading and depositary lending, while simultaneously missing or pretending not to understand that THAT IS THE VOLCKER RULE’S ENTIRE FUCKING POINT.” Emphasis, not mine.

The Volcker Rule now has two key exceptions: hedging and market making. But asking “a hedge or not a hedge?” is a pointless endeavor. To understand why, consider the complexity of hedging even a simple position. Suppose an investor believes the tech sector will do well and wants to put some capital to work in it, but also wants to hedge his bet in case tech stocks fall. One strategy might be to buy Apple Computer stock and go short IBM as a hedge. If the tech sector does badly and Apple’s stock doesn’t appreciate as planned, the short sale against IBM will profit in the overall decline, making some gains to offset the Apple loss. It should be obvious that these are not perfectly offsetting positions, but the idea is that one would hedge with an asset that’s expected to be highly correlated. While this increases the total size of the portfolio, it mitigates the risk of a backfired tech-sector trade. But of course, this thinking could be completely misguided. Apple might implode as IBM steals away its business, in which case the IBM stock doesn’t depreciate concurrently with the tech sector. Both positions lose money, and the investor is left with bupkis. It doesn’t mean that the IBM position wasn’t a “hedge.” It’s just a pretty bad hedge.

Additionally, consider shiny metals. Gold can be a great hedge, protecting against inflation when the value of paper money erodes, and it can even do relatively well in extreme deflationary environments as a form of currency that holds its purchasing power. But in muddled markets where there’s no clear consensus on the state of the world, when people aren’t running for the hills and not slobbering over the next bubble, gold prices can tank right along with everything else.

One cannot simply pronounce upon the JP Morgan portfolio—probably one as complex as it gets—without knowing the intimate details of their positions and their intentions. “Was this a hedge?” is a question that is ill-defined and almost impossible to answer. It is only a diversion and it will not result in the banking system becoming any safer.

A trade can be made for offensive purposes or defensively, as a hedge. Speculation increases an investor’s individual risk exposure, while hedging is an attempt to reduce it. And yet the same trade can be used in either way depending on circumstances. Selling shares of IBM can be the perfect hedge and it can be blatant speculation. Context means everything; no trade, taken by itself, can be squarely bucketed as “hedge” or “non-hedge.” It is always in relation to a given trade or to the portfolio as a whole. But this surely cannot be news to the reader—“for there is nothing either good or bad, but thinking makes it so” (Hamlet, Act 2 Scene 2). To Dimon, it is a hedge.

This ambiguity renders the Volcker Rule practically useless. The revised Volcker Rule permits not only hedging of individual trade ideas, but of the entire portfolio in aggregate. If determining whether a given trade was a hedge in relation to some other trade is hard, figuring out whether a trade was intended to hedge a multi-billion-dollar investment portfolio is virtually impossible. This undermines the spirit of the Volcker Rule and provides the loophole that Wall Street is looking for: since the definition of hedging is so ambiguous, virtually any trade can be justified as a hedge. But banning hedging is no solution either: if banks weren’t allowed to hedge their portfolios, it would create altogether new and disastrous risks.

Nor is the hedging exemption the only loophole in the Volcker Rule. The second big exemption allows banks to be market makers for their customers. Market making legitimately occurs for plenty of reasons. For one, investors greatly value anonymity when they come to the market. Additionally, market makers can help keep transactions flowing in otherwise illiquid markets with few counterparties. This part of their business model is crucial, for investment banks are selling their ability to effectively bridge the gap between buyers and sellers inasmuch as they sell their corporate finance services. As with hedging, there is no fine line between market making and prop trading. A market maker may unintentionally take securities into inventory for a long time if buyers are unavailable, thus building up a potentially profitable market position that looks a lot like speculation, whereas some proprietary traders make money by scalping fractions of pennies in high-speed trading, which looks very much like market making.

Looking at the re-engineered, 500-page Volcker Rule, it’s easy to see how things gets complicated. The Rule defines seven loose criteria all of which banks would have to meet in order to use the market making exemption. For example, banks are required to make money only from the spread between bid and ask prices, not from appreciation; they would also be required to have a comprehensive compliance program in place to prevent undue risk-taking. But a word like “undue” could feed a horde of corporate lawyers for decades. The fact that the seven principles are so poorly defined emphasizes the difficulty in navigating the details of the Volcker Rule.

Tragically, on the table is the deletion of an original requirement that CEOs must pledge that their firms are not engaging in any proprietary trading activities. It’s a principle aimed at increasing accountability and raising transparency, but it may be sacrificed to overcomplicated legal details. Regulators have been painstakingly focused on defining what exactly hedging is or is not, when we could happily stick to the spirit of the law: “We know it when we see it.”

Section 4

So what, after all, was JPMorgan doing, and did it violate the letter or the spirit of the Volcker Rule? While little is known about the intimate details of the trade itself, many analysts have suggested that the London Whale losses were investments in a credit index product with the memorable name “S9.CDX.IG,” comprised of credit default swaps on North American investment-grade (higher quality) corporate debt. To determine whether these investments were Volcker-compliant, we must raise a number of thorny questions. What strategy was being pursued, and is this a legitimate activity for the JPMorgan chief investment office to be pursuing? How much could this trade ultimately make or lose, and what can we tell about the trade’s systemic risk?

The product in question is an index comprised of a basket of credit default swaps (“CDS”) on low-risk corporate bonds, launched back in 2007. Companies sell bonds to investors to raise capital for internal projects. An investor who owns that bond can purchase CDS as a form of insurance, which is just protection in case the company in which they are invested goes bust. The investor pays a steady premium for the privilege of being protected; in the case of a default, the CDS seller guarantees the value of that bond. It's a great way to lower the risk of investing in a corporate bond, but these days investors can buy CDS contracts without owning the bond—these speculators bleed out a steady premium over time, but stand to make a killing if the underlying company fails.

Since then, four of those firms have defaulted: CIT, Fannie, Freddie and WaMu. A set of others are hunks of junk that might be headed for the same end: MBIA, Pulte, Sprint, and Radian are deep in junk-credit rating territory. It is quite unusual to see a massive amount of trading interest and positioning in such older, or “off-the-run,” derivatives. Nouriel Roubini’s team of economists has laid out a broad array of possible motivations for the trade. For example, it could have been a failed arbitrage, as the index has historically been cheap compared to the individual constituent components, and it may have suddenly been driven into the expensive territory. The economists think it’s unlikely that this was a big bet purposefully hidden in the bank’s too-big-to-fail balance sheet.

Were JPMorgan’s chief investment office a multi-billion-dollar hedge fund that imploded, this whole episode might raise a few eyebrows, but it would not be considered very important. At worst, a bailout of some kind might be orchestrated. But JPMorgan is not a hedge fund. It is a global bank with a long history, and it is the largest financial institution in the US. Importantly, like all commercial banks, it receives a huge subsidy via federal deposit insurance, and implicitly by being “too big to fail”—an idea confirmed in the events of 2008-2009, which showed that government will bail out the big banks no matter what happens, allowing them to operate with government guarantees even if the government makes no explicit claim to be guaranteeing them. For an institution and industry that receives subsidies and bailouts to speculate wildly on esoteric markets that most laymen can’t understand and that many experts would claim have little social value seems more than odd, but conspicuously unjust. And for gains to be kept by traders and management, while losses are borne largely by shareholders, depositors, and borrowers is the core principle behind the Volcker Rule.

This was a violation of the spirit of the Volcker Rule, and we can expect see wide-reaching fallout. The hubris of a too-big-to-fail financial institution gambling in the derivatives casino in the style of a hedge fund will surely intensify lawmakers’ efforts .

Section 5

JPMorgan’s $2 billion trading loss seems to give the argument in favor of a strong Volcker Rule some more ammunition. But would the JPM trading losses even have been prevented by Volcker's proposition? If the current version of the rule is implemented, the activities that Volcker wants to get rid of won’t disappear. They can easily migrate to other parts of the bank’s balance sheet, where they can be reclassified and disguised. It will become harder to see these trades clearly, and it will be much harder to regulate them.

The most important aspect of the rule is to eliminate bank activities that can be considered proprietary trading, but as we have seen, sorting out the difference between proprietary trading and legitimate hedging and market making is very difficult. One trader I spoke with called the difference “a metaphysical one,” and yet discussions around the topic assume that there are clear distinctions. Banks’ internal prop trading groups are being moved to new firms which are not under the same degree of scrutiny as their parent companies. In one quick move, prop trading groups that may be responsible for billions of dollars of capital are no longer reporting these positions as part of the bank’s balance sheet. Rather, they are reporting as hedge funds or other financial services firms under the regulations that apply to such firms.

The movement of trading activity from a bank to a new entity does not take the trade out of the market. Trades are still cleared, settled and custody with another bank in the form of a prime broker. This means that the trade is still a risk on one or another bank’s balance sheet, although perhaps the risk is now spread around between both the original bank and a newly engaged counterparty. Prime brokers are not necessarily reporting customer assets the same way they do the assets of a proprietary trading group. As a result, the prop trading groups’ trades have gone from being clearly identified in the marketplace to being more obscured as part of a clearing and settlement organization.

The idea of reducing bank risk is a good one. However, there is individual bank risk and there is systematic risk. Eliminating proprietary trading as per the modified Volcker Rule does take down some individual bank risk, but the risky trade in any case spreads out into the market with less transparency.

Paul Singer, a famous investor and the chief of Elliott Capital, has constantly pushed that the larger issue is that modern, diversified financial organizations have leveraged balance sheets with opaque derivatives, and the difference between portfolio hedging and prop trading is a meaningless one has not been resolved. Singer has publicly stressed that there needs to be a greater focus on deleveraging the system, and a proper approach to posting collateral. He's been viciously arguing that accounting standards must be more transparent, especially related to derivatives, and all organizations that trade should post margin, not just customers of large banks and financial institutions.

At several thousand pages, the Dodd-Frank legislation is horrendous, and the Volcker Rule at 300 pages is laughable. These cannot possibly be effective. If our experienced financial regulators are unable to monitor and control the financial system using heuristic principles—such as Volcker’s initial proposal—then we are fucked. And yet under the current financial system and its rules, we are fucked all the same. I leave it to the reader to decide if this is a state of affairs that can be corrected.

In the meantime, the financial industry must reinvent itself, its rules, and its regulatory process.

What’s happened to the sensible principles that we’ve smothered with dirt and detritus? If you can grant me the terrible comparison:

“A poor virgin, sir, an ill-favored thing, sir, but mine own. A poor humor of mine, sir, to take that that no man else will. Rich honesty dwells like a miser, sir, in a poor house, as your pearl in your foul oyster.” (As You Like It, Act V Scene 4)

Our lousy legislation is an ugly oyster. The pearl is in there somewhere.

¹ The Volcker Rule is the colloquial name for a proposal called "Prohibitions and restrictions on proprietary trading and certain interests in, and relationships with, hedge funds and private-equity funds,” which you can read here if you’re into that kind of thing.

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